Federal Politics and Budget Deficits:
Evidence from the States of India
Stuti Khemani
Development Research Group
World Bank, 1818 H Street, N.W.
Washington, DC 20433
Support from the World Bank’s Research Committee is gratefully acknowledged. I also thank Gunnar Eskeland, Stephen Howes, Shahrokh Fardoust, Edgardo Favaro, Manuela Ferro, Jonathan Rodden, and participants of the World Bank Economists Forum, April 30, 2002, for helpful comments. The findings, interpretations, and conclusions expressed in this paper are entirely those of the author, and do not necessarily represent the views of the World Bank, its Executive Directors, or the countries they represent.
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Abstract
This paper tests two predictions implied by models of the common-pool game in federations where subnational governments are more likely to have higher deficits because they do not internalize the macroeconomic effects of fiscal profligacy. The first is that subnational governments that belong to the same political party as the central government have lower spending and deficits because they are more likely to be influenced to internalize the macroeconomic effects of additional local spending; and the second is that subnational governments that are more dependent on intergovernmental transfers have higher spending and deficits. We find that in 15 major states of India over the period 1972-1995, states in fact have substantially higher spending and deficits (higher by about 10 percent of the sample average) when their government belongs to the same party as that governing at the center; and that intergovernmental grants tend to have a counter-intuitive negative effect on spending and deficits. The additional deficit of affiliated states is financed almost entirely by additional loans from the central government (as opposed to the market) leading to our interpretation that the central government in India distributes deficits across states in a similar manner to other fiscal transfers in order to gain political advantage. We argue that the evidence from India, contrasted with broader international evidence, indicates that the effect of fiscal institutions in a federation is sensitive to underlying political incentives. This underscores the overall importance of political institutions in determining the consolidated government deficit, relative to specific rules of intergovernmental transfers.
July 29, 2002
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1.Introduction
There is increasing concern in policy circles that developing countries that are rapidly decentralizing are exposed to the risk of macroeconomic instability due to growing fiscal deficits and soft budget constraints at subnational levels. While similar concerns exist for developed countries as well, the risk is perceived as exacerbated for developing countries because of lower potential revenue bases at local levels, higher dependence on federal transfers, and poor quality of legal institutions. The concern gains credence largely from individual case studies of sizable and persistent subnational deficits in federal countries like Argentina, Brazil, and India (Rodden, Eskeland, and Litvack 2001, World Bank 1999) and the theoretical and intuitive link between fiscal deficits and decentralization.
This link lies in a political economy perspective of fiscal federalism in which the geographical distribution of costs, benefits, and decisionmaking power over public expenditures leads to a “common pool” problem akin to the classic theory of distributive politics (Weingast, Shepsle, and Johnsen 1981, Inman and Fitts 1990, Aizenman 1998). If subnational governments take spending decisions, and are financed by transfers from the national government, which raises taxes, then the resulting amount of total government spending will be inefficient, because local authorities do not fully internalize the effects of their spending decisions on the consolidated government budget.
Within this framework, variations in political and institutional relations between the national and different subnational governments will have differential effects on the common pool problem, and hence on individual subnational fiscal policies. Jones, Sanguinetti, and Tommasi (2000) develop two hypotheses based on the common pool game for the impact of federal-provincial relations on spending by provincial governments in Argentina—one, provinces with higher federal transfers will have higher spending; and two, provinces where the governor is from the same party as the President will have lower spending. The first hypothesis is argued to result from the greater de-coupling of tax and spending decisions in provinces that are more favored by federal transfers. The second hypothesis follows the argument that the provincial governor who is politically affiliated with the national President will be more likely to internalize the effect of spending an additional unit of national resources due to internal party discipline. The empirical evidence from the Argentine provinces is consistent with both hypotheses. Similar evidence for the impact of intergovernmental transfers has been found for German provinces (Rodden 2000), the U.S. states (Rogers and Rogers 2000) and in cross-country analysis (Rodden 2002). This paper estimates the effect of political and fiscal relations between the national and provincial governments on provincial fiscal deficits in another large federation of the developing world, India, to examine whether the above implications of the common pool problem holds under an arguably different model of federal politics.
Ter-Minassian (1997), Rodden, Eskeland, and Litvack (2001) and Inman (2001) study the mechanisms and institutions that support fiscal discipline, or indiscipline, at the subnational level. The underlying story is essentially one of errant local governments yielding to the temptation of shifting their own budgetary costs onto the central government. Fiscal profligacy by subnational governments is (unwillingly) rewarded by the national government as it is unable to commit in advance to a policy of “no bailouts” when a local jurisdiction is in trouble. Specific deficit bailouts and general federal transfers both “soften” the local government’s budget constraint and lead to inefficient resource allocation (Inman 2001). The national government is thus vulnerable to strategic manipulation by local governments because of its inability to commit to a “no-bailout” policy.
The above story of a center vulnerable to subnational fiscal profligacy is based upon models of electoral competition where the national government is elected from national constituencies and evaluated on the basis of macroeconomic outcomes. Thus, the national government has more powerful incentives for fiscal conservatism than each subnational government. In this model, greater fiscal decentralization would be associated with higher deficits, other things being equal (Weingast, Shepsle, and Johnsen 1981). An implication of this model tested by Jones, Sanguinetti, and Tomassi (2000), as indicated above, is that subnational governments that are politically affiliated with the center will be less likely to engage in opportunistic behavior, and should have lower deficits.
Institutions of fiscal decentralization may assist in providing perverse incentives for subnational expenditures by increasing the disconnect between tax and spending decisions. Specifically, when subnational governments are largely dependent on intergovernmental transfers rather than locally generated revenues, and where transfers are designed to assist fiscally disadvantaged states, the fiscal institutions may facilitate over-borrowing and over-spending by subnational governments because the central government finds it harder to commit to a “no-bailout” policy (Rodden 2002). Indian fiscal federalism is indeed characterized by vertical fiscal imbalance, where the states have undertaken 50-60 percent of total government spending in the last decade, of which 30-40 percent has been financed by central transfers (Rao and Singh 2000). Intergovernmental transfers in India have also long been assumed to provide perverse incentives to state governments because of the so-called “gap-filling” approach where some transfers are directed to cover the discrepancy between planned expenditures and expected revenues (Rao 1998, McCarten 2001).
In this paper we use variation in party affiliation and intergovernmental grants across 15 major states of India over a 24-year period from 1972-95 to test the above implications. Contrary to the expectations outlined above we find that in periods when a state government belongs to the same party as that at the center the state has higher than average fiscal deficits, and greater transfers are correlated with lower spending and lower deficits. The partisan effect is large, with deficits in affiliated states being 10 percent higher on average than deficits in non-affiliated states. Additional evidence indicates that among affiliated states the central ruling party targets those states where it controls a smaller proportion of seats to the national legislature, and thus where it has more seats to gain.
We argue that this evidence is consistent with a particular model of federal politics that exists in India, where the central government favors additional resource transfers to politically affiliated subnational governments to further its political objectives. We find that the higher deficits of affiliated states is entirely financed by greater loans from the central government, as opposed to other forms of market debt, and interpret this as evidence that the center opportunistically distributes deficits across subnational governments in much the same way as other federal transfers.This political effect on deficits is consistent with recent evidence on the political determinants of systematic channels of intergovernmental transfers to the states in India (Dasgupta, Dhillon, and Dutta 2001, Khemani 2002, and Rao and Singh 2000).
The contrast of the Indian experience versus other international evidence suggests that the effect of institutions of fiscal decentralization on subnational spending and deficits is dependent on the nature of the political incentive environment. This analysis thus provides a rationale to somewhat dissociate the problem of subnational fiscal deficits from the institutions of fiscal decentralization (such as rules of intergovernment fiscal transfers), and renew focus on general political determinants of deficits, or on institutions of political decentralization. We develop a simple model where the counter-intuitive effects of political partisanship and intergovernment transfers on subnational deficits in India can exist in equilibrium under specific electoral institutions and voting behavior. The empirical evidence provided here may motivate the development of a more general theory, and subsequent cross-country empirical testing, of the sensitivity of the impact of fiscal decentralization instruments to variation in federal political institutions around the world.
There exists a substantial macroeconomic literature on the political and institutional determinants of fiscal deficits of the national government (see Alesina and Perotti 1995, 1996 for excellent surveys and von Hagen, 1992). Some of this political and institutional analysis carries over to the case of subnational governments, with a political game played within subnational governments between different agents, in addition to any federal game. Poterba (1994) and Alt and Lowry (1994) examine the effect of divided governments on fiscal policy in the American states, and find that adjustment to fiscal shocks is slower in states with different parties controlling the state legislature and executive. Poterba (1996) provides a survey of the impact of legislated budgetary institutions on state fiscal policy—states with balanced budget rules adjust faster to fiscal shocks. However, this strand of literature on budget deficits did not study the impact of broader political and constitutional institutions like electoral rules and political regimes.
The empirical evidence for the Indian states shows that political institutions governing relations between the central and state governments is a significant determinant of subnational deficits, and provides additional motivation for delving deeper into the political incentives driving budget deficits in a federation. Partisan affiliation between the central and state governments in fact stands out as the only significant political determinant of subnational deficits, to the exclusion of other plausible political and institutional determinants that have been tested in the received literature, such as election cycles, fragmented legislatures, and budgetary institutions.
In the next section we lay out a theoretical framework for the impact of federal political institutions on subnational deficits, that motivates our empirical specification and interpretation of the evidence. Section 3 describes the empirical methodology and the data, and presents the results. Section 4 concludes, with some discussion of policy implications for fiscal relations in the Indian federation in the post-1995 era of coalition politics at the center.
2.Analytical framework
Variation in subnational deficits and spending, after controlling for basic economic conditions that are fundamental determinants of deficits, can be thought of as the result of strategic interaction between central and subnational governments. We adopt this approach here and develop a simple game theoretic framework to examine the role of federal political relations and intergovernmental transfers in determining subnational deficits. The basic analytical framework used here is drawn from Inman’s (2001) characterization of fiscal bargaining between local and national governments. Ultimately, the relative significance of political affiliation and intergovernmental transfers in determining subnational deficits is an empirical question, and the primary focus of this study.
Figure 1 lays out the sequential game between the provincial and central government. The “status-quo” of this game is the outcome of the central government’s determination of overall resource allocation to the provincial governments to optimize its political objectives. The provincial government deficit is determined at the nationally optimal level (), which is fully funded by the central government through loans (). However, the provincial government, as the first mover in this game, can undertake an action of over-spending and increasing its deficit () beyond the optimal level that is financed systematically by central loans. The central government may respond to this additional deficit by either financing it through additional loans () or leaving the local government to fund its additional deficit through fiscal retrenchment, raising additional taxes or lowering spending. The payoffs to the central and provincial governments may be expressed as the difference between benefits and costs for each pair of actions undertaken.
Figure 1.
Center’s Payoff:STATUS QUO
Province’s Payoff:
Note that given our definition of the status quo as the centrally determined optimal solution, we have . However, the equilibrium of this game could be (,), that is where the local government over-spends and central government provides additional loans to fund the additional deficit, if the following conditions are satisfied:
(1)
(2)
(3)
The recent literature on institutions of fiscal federalism in a cross-section of countries implies that these conditions for the equilibrium of (,) are more likely to hold in countries characterized by greater dependence of provincial governments on intergovernmental transfers. In this “common pool” approach, the reliance on central transfers would lead to a payoff structure such that condition (1) holds, and therefore the central government cannot credibly commit in advance to a “no-bailout” policy. The argument is usually along the following lines: voters distinguish between the role of provincial and central governments, holding the former responsible for the provision of local public goods and the latter for general macroeconomic stability and insurance from unexpected shocks. However, they are unable to perfectly distinguish whether fiscal problems and economic hardships are due to unsustainable actions taken by the provincial government or inaction by the central government during times of negative economic shocks. Hence, in the event of local fiscal indiscipline the central government is not likely to withhold a bailout because that would be politically costly. Knowing this, local governments have incentives to over-spend. By this same argument, within countries provinces that are more dependent on central transfers would be more likely to have higher spending and deficits.
Within countries the conditions for this equilibrium are also more likely to hold the greater is the political bargaining power of a provincial government, leading to a correlation between the level of provincial deficits and spending and indicators of provincial bargaining power. Hence, large provincial governments with a large vote-base or provinces with a pivotal vote-base are more likely to receive additional central funds to finance additional spending. Furthermore, large provinces with significant fiscal externalities for the rest of the country may be “too big to fail” and also likely to have higher spending and deficits financed by central loans.
The main question of interest for our purposes here is that controlling for size and political representation, how does spending and deficits vary across provinces with different political affiliations and varying degrees of dependence on intergovernmental transfers? Variation in political affiliation across provinces could be correlated with variation in provincial deficits because of the role affiliation plays in the central determination of (d, l), and not as a result of strategic fiscal bargaining between central and provincial governments. Khemani (2002) develops a model of central resource allocation where the solution is characterized by greater central transfers to politically affiliated states because the center gains political advantage in these states. Central loans, or central guarantees of market loans, are instruments of resource transfer which would thus also favor affiliated states according to the model, implying higher (d, l) for affiliated as opposed to unaffiliated states.
In this section we focus on the conditions under which fiscal bargaining between the center and provinces may lead to higher subnational deficits. We outline a model of political relations in a federation to generate payoff functions for the center-province game described above and examine the conditions under which (,) would be an equilibrium, leading to variation in deficits across provinces as a result of different conditions of center-province bargaining.